Barclays' exit from energy trading stirs concerns over liquidity

British bank Barclays Plc has joined the list of top banks to exit energy trading, an exodus that analysts say raises concern among oil producers that falling liquidity means they cannot use derivatives for their basic function: to hedge risk by locking in future prices.

Wall Street firms have scaled back in commodity markets since the 2008 financial crisis from owning physical assets or taking positions in the market in the face of regulatory scrutiny. The��banks were big players in the market for derivatives years into the future.

The departure of Barclays exacerbates the scarcity of counterparties for trade when producers are trying to hedge their production for 2018 and beyond, potentially raising the cost to lock in that output.

That increase could force cash-strapped producers to forgo protection altogether, putting them at risk if the market takes another leg down.

Some producers seek to lock in future profits and fund expansion through selling as much as 80 percent of production years into the future.

"It's one less bank willing to make a trade in the market, which reduces liquidity overall. That's one less source of credit and one less counterparty," said John Saucer, vice president of research and analysis at Mobius Risk Group.

On Thursday, Barclays said it would close its energy business within the 'Macro' trading division, according to an internal memo obtained by Reuters, a move to better maintain resources. They follow a string of other big banks who, with profits hampered by toughening financial regulations, have chosen to exit.

Executives and traders within the industry said that Barclays' move was not surprising as it had been scaling down in recent years. But it represents the departure of another former top-five player from the energy space. Other big players who have already exited the market include RBS Sempra in 2010 and Deutsche Bank three years ago.

Merchant traders such as Vitol Group, Mercuria Energy Group and Glencore Plc sought to fill the vacuum left by the investment banks.

But the merchant traders have preferred to trade around their own physical positions, which are often linked to derivatives contracts with nearby expirations.

"Merchant books are physically oriented. They don't offer the same type of liquidity that the banks do," Saucer added. "When they're there, it's patchy and specific. It's ancillary to the other stuff they're doing."������

That means merchant traders have little incentive to trade years into the future, and so have failed to plug the gap left by the big banks. Merchants also have tighter credit availability than banks, so are less willing to tie up capital in long-distant futures trade.

Barclays has been reducing its footprint for a while, having announced a retreat from precious metals in January. Two sources familiar with the matter said that Barclays' business with oil producers seemed to be reducing in size over the years, it retained a decent refinery business.

The memo noted that the Macro's energy business accounted for less than two percent of overall revenue for the markets business at the British lender.

Still, those with a stronger financial position and a larger presence, including heavy hitters like Goldman Sachs & Co[GSGSC.UL] or JPMorgan Chase & Co , remain in the market and can absorb additional hedging needs. If one of the current larger players dropped out, that would be much more concerning because it would greatly increase the price to hedge, traders said.

One point of uncertainty, they added, was what Barclays was going to do with its trade book. Analysts pointed out that Barclays could unwind hedges that it already conducted with market participants. The other option would be to sell the hedge book, thereby passing on any risk to another player. That could be prime opportunity for banks or merchants wanting to grow.

"We think of this in relationship terms and if there was a specific reason to trade with Barclays. Sadly, increasingly, there wasn't," said Steve Sinos, vice president of Mercatus Energy Advisors, which works with energy producers and consumers. "They were competitive, but weren't providing anything outstanding. And, they didn't have a lot of lending with our clients."

(Additional reporting by Jessica Resnick-Ault in New York; Editing by Simon Webb and Marguerita Choy)